Cara Kiley owns a newly issued U.S. government agency fixed-rate pass-through mortgage backed security (MBS) and wants to evaluate the sensitivity of its principal cash flow to the following interest rate scenario:
• Interest rates instantaneously decline by 250 basis points for all maturities, remain there for one year, and then,
• Interest rates instantaneously increase 350 basis points for all maturities and remain there for the next year.
Currently, the MBS is priced close to par and the yield curve is "flat." Cara does not expect the shape of the yield curve to change during her interest rate scenario.
a. (1) State whether, in the interest rate scenario described, the MBS principal cash flows:
• Increase or decrease in the first year
• Increase or decrease in the second year
(2) Discuss the reason why principal cash flows change.
Cara also wants to evaluate the price sensitivity of her MBS to changes in interest rates.
She knows that modified duration and effective duration are two possible measures she could use to evaluate price sensitivity.
b. Select and justify with one reason which duration measure Cara should use to evaluate the price sensitivity of her MBS.
Cara also owns a newly issued U.S. government agency collateralized mortgage obligation interest-only (IO) security.
c. State whether the IO security price increases or decreases in the first year of the interest rate scenario described. Justify your response.